How does an IPO work?

Every company, big or small, functions on one thing: capital. Almost every business starts as a private entity with a handful of people funding its initial operations. Similarly, investors look forward to gaining profits from their investment through the company’s expansion. They believe that the best time to invest in a good company is when it lists for the first time on the stock market. In this way, the higher the company profits, the higher its share price.

The best investment route for an investor in a company is through an IPO. However, before diving into how an IPO works, let’s break down the process and definition of an IPO.

What is an IPO?

An IPO, or Initial Public Offering, is when a company sells its shares to the general public for the first time. The shares, previously held by the company executives, are offered to the common people in exchange for money or capital, which the business may use for expansion purposes or to pay off debt. Once the IPO process is complete, the company is declared publicly listed, and its shares can be traded in the open market.

Once a company becomes publicly traded, a part of its ownership is sold to investors. Typically, a company initiates IPO for the following purposes:

  • To infuse fresh equity capital.
  • To facilitate the trading of its assets.
  • To raise capital for various requirements.
  • To monetize the investment of its private stakeholders.

How does an IPO work?

Companies have to abide by the IPO process in India - as stipulated by stock exchanges - before their shares are eligible to be publicly traded. In India, SEBI governs the IPO process and has listed various steps included in the process of ‘How an IPO works in India’. The detailed process is as follows:

Step 1: Hiring Of An Underwriter Or Investment Bank

The IPO process demands a detailed analysis of the financial parameters of the company which falls under the domain of financial experts such as investment banks. The underwriters of the investment bank manage the overall IPO issue and work as an intermediary between the company and its potential investors.

The experts also study other crucial parameters of the company and sign an underwriting agreement which includes the following components:

  • Details of the deal
  • Amount to be raised
  • Details of securities being issued

Step 2: Registration For IPO

As per the Indian Companies Act, It is mandatory for every company to prepare and issue an IPO registration statement along with a draft prospectus, called a (Draft Red Herring Prospectus (DRHP). The prospectus aims to provide investors with the following information:

  • Risk factors that can impact the company’s financials.
  • Use of Proceeds to let investors know the aim of raising capital.
  • Industry description to detail the industry segment and its factors that can affect the company.
  • Business description to bring clarity about the business operations of the company.
  • Management details to provide information on the key people.
  • Financial description to list financial statements along with the auditor's report.
  • Legal and miscellaneous information to detail the litigation and other information.

Step 3: SEBI Verification

Once the company’s registration statement and the DRHP are submitted to the registrar, the company can make a formal IPO application with SEBI. Later, SEBI verifies the disclosure of facts by the company. If the application is approved, the company can announce a date for its IPO.

Step 4: Stock Exchange Application

After approval from SEBI, the company can apply to the stock exchanges for floating its IPO issue.

Step 5: Marketing

Once the IPO issue is finalized, the company can begin marketing its issue. This could include social media marketing, roadshows, advertisements, etc. The aim is to ensure that the issue is subscribed to by as many investors as possible.

Step 6: Pricing of the issue

Before the company’s IPO goes public, the company consults the investment bankers to finalize the price of each share, either through Fixed Price IPO or Book Building Offering. In Fixed Price Offering, the price of the company’s stocks is announced in advance. In the event of Book Building Offering, a price range of 20% is announced, following which investors can place their bids within the price bracket.

Step 7: The Bidding process

This is where the investors place their bids as per the company’s quoted Lot price. The booking is typically open from three to five working days, and investors can revise their bids within the stipulated time. After completion of the bidding process, the company determines the Cut-Off price, which is the final rate at which the issue is sold.

Step 8: Allotment of shares

After closing the IPO, the company, along with the underwriters, decides the number of shares to be allotted to each applicant. If the issue was oversubscribed, applicants get partial shares in 10 working days.

When can a company file for an IPO?

A company can file an IPO if:

  • It has had an operating profit of a minimum of 15 crores for at least 3 out of the last 5 years.
  • It has had net tangible assets of at least 3 crores every year for the last 3 years.
  • If the above is not fulfilled, it can still file for an IPO. In this case, the company has to be a book building issue with 75% of the shares reserved for Qualified Institutional investors (QII).

As IPOs can be a great start and an ideal option to diversify your portfolio. You can consider applying to IPOs of fundamentally strong companies. However, the prerequisite is that you can open a free Demat account with IIFL through the website or by downloading the IIFL Markets app from the app store. Once you have an active Demat account, you can apply to any of your preferred IPOs.

Happy trading!

Frequently Asked Questions Expand All

The shareholders of every company become part owners in the proportion of the percentage of shares they hold. For example, if you hold 1,000 shares of XYZ company and it makes up for 1% of the company value, you are the owner of 1% of the company.

The pricing is done through two methods: Fixed issue or book building issue. In the former, a specific price of each share is fixed. In the latter, the company gives a range to the investors to choose a price.

You can buy an IPO stock by applying to the IPO issue of a company once it is live. You will need a Demat account and a trading account with an experienced stockbroker such as IIFL to begin trading.